Most of these passive investments track market capitalisation indices such as the S&P/ASX 200 Accumulation Index (S&P/ASX 200).
As the name suggests, these indices are constructed using market capitalisation, so the larger companies with larger market capitalisations, represent a larger part of the index.
Australian investors in passive funds tracking market capitalisation indices, happy with past returns, are now in the awkward situation of being stuck with stocks that may be overpriced.
This is a problem in a concentrated market like Australia, where the top 10 stocks make up over 50 per cent of the market.
Additionally, the Australian market is not very diversified so if bubbles form in a particular sector, passive investors may be unintentionally exposed.
Lack of diversification in Australia means sectors such as IT and healthcare are underrepresented in many passive Australian equity funds.
The recent correction in the price of Australian banks has highlighted the shortcomings of using market capitalisation as an investment strategy in a concentrated market like Australia.
The Financials ex-A-REITs sector is over 40 per cent of the S&P/ASX 200 with the four banks making up over 30 per cent.
Investors in low cost funds tracking the S&P/ASX 200 have been allocating more and more to financials as their prices have risen, even though there may have been better opportunities for growth elsewhere.
The problem now emerging by tracking a market capitalisation index is investors have been buying too much overpriced stocks.
When the market corrected, having bought more of these stocks in the lead-up to the correction was not optimal.
The large-cap party may be over.
Last month Van Eck Global released research illustrating that an investment portfolio following an equal weight index would have produced significantly higher long-term returns and better diversification than one following a traditional market capitalisation weighted index.
In summary the paper shows:
- Non-market capitalisation weighted indices have become the dominant theme in index innovation.
- Equal weight investing is not new. Equally weighted indices have demonstrable outperformance relative to their market capitalisation weighted counterparts.
- Criticism of equal weight investing has concentrated on turnover and capacity. In practice neither is an issue with carefully developed index rules.
- Researchers and academics from varied institutions such as The University of London’s Cass Business School, EDHEC Business School, Goethe University and Australia’s own Monash University, continue to demonstrate the long-term outperformance of equal weight investing.
Russel Chesler is the director for investments and portfolio strategy at Market Vectors.
